Will Too Little Capital Stall Global Growth?

Economic models are now forecasting a period of strong global growth. Economists ask whether the need for capital will raise interest rates, bringing growth to a halt.

The world economy has obstinately kept growing, albeit lethargically, even while central bankers have put growth below price stability in their order of monetary-policy priorities. Now evidence is mounting that the world’s slow-growth period may break out into more vigorous expansion. With prices under control for now, economists are beginning to ask whether a new cloud is casting its shadow: Is there enough capital to adequately fund continued world growth?

A capital shortage - with high rates of interest - would exert downward pressure on global stock markets. In short, growth would sputter and a global slowdown would ensue. This scenario doesn’t impress Edwin Rubenstein, an economist himself as well as a political and policy consultant, even though a number of prominent economists, including Jacob Frenkel, former chief economist at the International Monetary Fund, have worried recently that there is not enough capital to go around.

Mr. Rubenstein argues that mature economies - like those of the United States, Europe and Japan - require less savings and investment, in relative terms, than they did when they were less mature. He points to the move of their economies away from capital-intensive sectors like manufacturing into less capital-intensive sectors like services. Furthermore, he states, this shift to services is making obsolete the old economic model of investment which he claims now seriously underrepresents the investment spending of developed countries.

Providing another reason for optimism, Mr. Rubenstein suggests that high savings rates in the developing countries (24.6 percent of G.D.P. in 1994) will reduce the projected $2 trillion investment gap over the next 10 years between domestic savings in developing countries and potentially profitable investments there. His conclusion is that over the long haul, capital flows from the developed world, when combined with these high rates of savings, are likely to be sufficient to propel much of the developing world into the ranks of economically advanced nations.

Economists, as the saying goes, are always looking for the cloud in the silver lining. Whether the economy is growing, slowing or moving not at all is grist for anxiety, with each turn in direction presenting its own negative implications for business and society.

Until recently, most of the worry focused on the relationship between growth and inflation. For at least a decade, the world's central bankers put price stability above growth and even over currency exchange rates in the hierarchy of monetary-policy options. And for the last five years, they largely achieved their aims: the world economy has grown--albeit sluggishly and unevenly--while prices have generally remained flat, especially in the developed world.

But now, with prices under control, economists are beginning to ask whether a new cloud is casting its shadow: Is there enough capital to adequately fund continued world growth?

Economists pose this question because evidence is beginning to mount that the world's slow-growth period--roughly 1989 to 1995--may be finally drawing to a close. This conjecture has been confirmed by statistics from the Organization for Economic Cooperation and Development in Paris. After several false starts, according to the O.E.C.D., Europe's economy is expected to grow by 3 percent in 1995 with excellent prospects for even faster growth in 1996. Japan's long and painful slump is beginning to abate as its companies return to profitability, while the United States heads into its sixth year of generally accelerating growth. In addition, growth in Eastern Europe, including Russia, is likely to be positive for the first time since the fall of the Berlin Wall, according to the latest United Nations Economic Survey. China is also expected to continue its vigorous, albeit uneven, expansion while the forecast for Latin America and the rest of Asia, including India, also looks surprisingly bright. Only Africa remains mired in decline.

With robust global growth there will be no shortage of opportunities for businesses that are ready to ride the wave.

But here is where economists worry. If investment demand outstrips the supply of excess savings, interest costs will rise for countries and corporations. Around the world, housing, autos and other industries that depend upon ample supplies of credit would be hurt. A capital shortage--with high rates of interest--would put downward pressure on global stock markets. In short, growth would sputter and a global slowdown would ensue.

GLOBAL GROWTH

A number of prominent economists, including Jacob Frenkel, former chief economist at the International Monetary Fund, have worried recently that there is not enough capital to go around. Though this is not the first time that the international economy has grown in sync--it also happened during the late 1980's--a host of new factors makes capital shortages more likely this time around, Mr. Frenkel and others believe.

On the demand side, there are the massive capital requirements generated by the movement away from socialism. For example, Liu Zhongli, China's Finance Minister, has suggested that his country would have to borrow about $500 billion in the world's capital markets over the next decade to fund its growth. An economically resurgent Eastern Europe could easily absorb a similar amount. In addition, as India begins to emerge from its long economic slumber, it too will require capital. And an expanding developed world has its own capital needs.

Over the next 10 years, there is likely to be a significant gap -- perhaps as much as $2 trillion, according to the General Accounting Office -- between domestic savings in developing and former socialist countries and potentially profitable investments there. For these countries to realize their potential growth, this capital shortfall must be made up from unallocated savings in the developed world.

GLOBAL GROWTH

A number of prominent economists, including Jacob Frenkel, former chief economist at the International Monetary Fund, have worried recently that there is not enough capital to go around. Though this is not the first time that the international economy has grown in sync--it also happened during the late 1980's--a host of new factors makes capital shortages more likely this time around, Mr. Frenkel and others believe.

On the demand side, there are the massive capital requirements generated by the movement away from socialism. For example, Liu Zhongli, China's Finance Minister, has suggested that his country would have to borrow about $500 billion in the world's capital markets over the next decade to fund its growth. An economically resurgent Eastern Europe could easily absorb a similar amount. In addition, as India begins to emerge from its long economic slumber, it too will require capital. And an expanding developed world has its own capital needs.

Over the next 10 years, there is likely to be a significant gap -- perhaps as much as $2 trillion, according to the General Accounting Office -- between domestic savings in developing and former socialist countries and potentially profitable investments there. For these countries to realize their potential growth, this capital shortfall must be made up from unallocated savings in the developed world.

THE BIG THREE CAPITAL PROVIDERS

The concerns expressed by Mr. Frenkel have been echoed on the supply side by Michael Mussa, research director at the I.M.F., and John M. Hennessy, chief executive of CS First Boston in New York.

These worries--which I do not share--are not entirely unfounded. On average, the O.E.C.D. nations saved about 3 fewer percentage points of G.D.P. in the 1980's than in the 60's or the 70's. The decline was nearly universal; only Norway, Portugal and Turkey registered higher savings rates over this period. The experience of the 90's has so far been mixed, with both dramatic increases and declines in private savings making the future difficult to predict. Despite recent changes in savings rates, it is hard to believe that this longer-term trend will suddenly be reversed.

While the savings rate in the United States has been stagnant or falling, the Federal deficit has been growing. As a result, less domestic savings are available to support business investment. To fill the gap, the United States imports capital from the rest of the world. Indeed, the United States is now the world's largest capital importer. The bilateral capital flow from Japan to the United States--about $80 billion a year--represents about one-third of the total global net capital flows. The huge American appetite for capital dwarfs that of any other country.

This represents a sharp break with history. For almost a century, the United States was a large net exporter of capital--mainly because it ran a substantial trade surplus for nearly the entire time. Since 1981, however, the country's current account--the broadest measure of trade and investment--has been in the red. In 1994, the trade deficit surged to $156 billion, up 50 percent from 1993. The deficit is expected to be at near-record levels again in 1995.

Germany has recently undergone a similar transformation. For much of the period following World War II, it exported capital; no more. Since unification, Germany has channeled its excess savings into its newly assimilated eastern half, giving credence to those who believe in an impending capital scarcity. Instead of exporting capital equal to 5.5 percent of its G.D.P.--Germany's traditional level--it is likely to import capital equal to between 3 and 4 percent of G.D.P., and that is for the foreseeable future.

Japan still lends abroad. But a weakened banking system and, for the last three years, increased Government borrowing have severely curtailed its role as the world's banker. In addition, Japan's real estate crisis--it has as much as $1 trillion in bad real estate loans, according to Yukiko Ohara, a banking analyst at UBS Securities Inc.--could strain the system even further. The Government has responded to the banking emergency by cutting interest rates to near zero, in real terms, which has led to a flight away from the yen and resulted in a sharp appreciation of the dollar. The banking problem has produced the so-called Japan premium, whereby Japanese banks are paying an average of 19 basis points above the going rate to borrow in dollars, according to the Congressional Research Service.

Even without the severe problems in banking, Japan's financial system is strained. As a result of the efforts to rebuild earthquake-shattered Kobe and to lift the economy out of recession, Japan is expected to be the world's largest issuer of Government bonds in 1995--surpassing even the United States, according to estimates by J.P. Morgan & Company. That would divert a significant source of capital away from international uses.

Even so, Japan--and its companies--are still flush with capital, mainly dollars, largely as a result of that nation's huge trade surpluses. But there is a difference between today's Japanese dollar recycling and the recycling that was prevalent during the 80's. Back then, Japan's surplus dollars went mostly into long-term American investments like 30-year Treasury securities. In addition, Japanese companies were investing directly in American factories and in real estate. Japanese capital flooding into the United States freed American capital to go overseas.

Today, however, because of investor nervousness and the country's more pressing domestic concerns, most of Japan's lending is short-term. It is also highly interest-rate sensitive due to the volatility of the dollar and increased uncertainty in the world's foreign-exchange markets. Outflows of capital from Japan for long-term investment have shrunk to one-tenth their level in the 80's, according to a study by Merrill Lynch & Company. And if the predictions of the analysts are correct and Japan's trade surplus falls over the next few years, there will be further pressure on the developed world's savings.

These and other claims on the world's traditional sources of capital appear to support those who argue that a global slowdown is imminent, brought about by capital insufficiencies. The 1990-91 recession in the United States, which was deepened and prolonged by a domestic scarcity of capital that resulted from the collapse of the savings and loan industry, is what many analysts fear could happen on a global level.

SO IS THERE A SHORTAGE?

Capital has been flowing to the developing world. After averaging only $8.8 billion a year in the 1983-89 period, capital flows from the developed to the developing world surged to $161 billion in 1993, before falling to $134 billion in 1994, according to the World Bank. In addition, net inflows of all direct investment to developing nations grew to $34 billion a year during the 1990-93 period, from $13 billion a year between 1983-89, before also contracting in 1994.

Though the increase in capital flows is sharp over the long haul, why the sudden downturn in 1994?

To begin with, not every year can be a record year. Certainly not the year in which the Federal Reserve increased interest rates dramatically, as it did in 1994.

But rather than attribute the falloff to a crunch, many observers see something else at work. "The problem isn't a scarcity of capital at attractive rates," said George Goldberger, a former senior executive at W.R. Grace & Company who now advises companies in Eastern Europe. "The problem is that entrepreneurs are still few and far between in emerging markets."

This is a problem so symptomatic of developing countries that there is a term for it--"funds surplus, project drought." The term was first used to describe Egypt in the early 80's, when billions of dollars of American aid, following the Camp David accords, had to sit idle until projects could be devised to accommodate them. As new projects were conceived, the money began to flow.

Another reason for the slowdown is the Mexican meltdown. Beginning in mid-1994, when the Mexican Government stopped publishing its capital reserve figures, investors began to grow wary of the risks inherent in developing countries. Five months later, when the peso collapsed, it sent a chill through the international investment community.

Though exact figures are not yet available for 1995, there is anecdotal evidence that the money is beginning to flow once more. But this time, investors are more savvy. Bankers, for example, are lending to borrowers that have not achieved investment-grade status by tying the loans to specific revenue sources. In 1994, for example, Salomon Brothers underwrote $50 million of five-year bonds for Aeromexico in a private placement securitized by the airline's dollar-denominated ticket sales. This type of creativity will no doubt entice capital into markets that were otherwise deemed to be too risky.

So why did the flow of capital fall off in 1994? My best guess is that it had more to do with the economic slump in Europe and Japan than with capital shortages. This perception is echoed by Stephen S. Roach, chief economist at Morgan Stanley in New York. If we are correct, and there is no capital shortage, the flow of funds should increase as the economies of Europe and Japan strengthen over the next year or so.

There is another important, but largely overlooked, reason why investment in developing- and transitional-economy countries may get back on the growth path, even with the decline in developed-country savings. And that is the fact that mature economies--like those of the United States, Europe and Japan--require less savings and investment, when measured as a share of G.D.P., than they did when they were less mature.

Real Long-Term Interest Rates(1)

(1) Long-term interest rates less inflation expectations generated by smoothing changes in the G.D.P. deflator using a Hodrick-Prescott filter.Source: O.E.C.D.

This contention is borne out by history. Following World War II, Japan and Europe needed massive levels of savings to finance their rebuilding efforts. After approximately 20 years, those high rates of savings and investment had produced world-class infrastructures, factories and service industries. But once Europe and Japan reached rough economic parity with the United States, their need for investment was diminished. As a consequence, savings and investment decreased, when measured against G.D.P., while consumption went up, notes Barry Herman, director of the United Nations Economic Survey Unit. That was the case even in Japan, where artificially low interest rates were maintained , although investment tapered off to a lesser extent there than in other parts of the developed world.

This decrease in savings was not a consequence of capital scarcities, but rather of material abundance, the result of the two decades of savings and investment. Is it any wonder that it takes less capital to repave a road than to build one in the first place? Or that once the road is in, that it costs less to build another one near it? Similarly, does anyone dispute that it costs less to upgrade a factory--when measured as a share of G.D.P.--than to construct one?

The movement of the world's mature economies away from capital-intensive sectors like manufacturing, into less capital-intensive sectors like services, also signals that their need for capital will not be as great in the future. But even more important, with the shift to services, the old economic model of investment breaks down.

In the service sectors, more investment is required in people than in machines. While it once took coke ovens and steel mills to become an international economic powerhouse--items classical economists clearly count as investment--now it takes the production of Ph.D.'s in biotechnology, software development and marketing.

But graduate courses at the Massachusetts Institute of Technology or Cambridge University are not counted as investments in economic surveys. Not only that, much of the funding for this type of investment comes from public, rather than private, sources. Because these expenditures--which really are investments in the future--are omitted from the investment statistics altogether, developed countries seriously underrepresent their investment spending.

Moreover, the price of investment goods, such as machinery, computers and buildings, has generally declined relative to the price of other components of the G.D.P. Conventional investment-rate measures ignore these price changes. When prices are taken into account, however, the real investment rates of the late 80's exceed those of the late 70's. And by the same token, Mr. Herman of the U.N. expects the developed world to invest a larger real share of G.D.P. in 1995 than it did in the 80's.

There is another reason for optimism. According to an I.M.F. survey, the gross savings rate for developing nations was about 24.6 percent of G.D.P. in 1994--4.5 percentage points more than the gross average savings rate projected for industrial countries. With savings rates this high, the investment gap may be far less than the $2 trillion projected in the G.A.O. study.

Indeed, at 24.6 percent, the developing world's savings rate is now roughly equivalent to the rates in Europe and Japan immediately following World War II, during the great period of rebuilding. Over the long haul, capital flows from the developed world, when combined with these high rates of savings, are likely to be sufficient to propel much of the developing world into the ranks of economically advanced nations.

In 1995, in the United States, Social Security, Medicare and Medicaid will appropriate 8.3 percent of the G.D.P., up from 4 percent in 1970. Even with Washington finally acting to close the budget deficit, the share of G.D.P. going to fund entitlement programs is projected to continue rising. If more cuts are not made down the line, the Federal debt could equal 200 percent of the G.D.P. by the year 2030, roughly three times the current ratio, according to estimates by the General Accounting Office and others.

Even worse numbers are forecast for other developed countries. If existing entitlement programs are kept intact, Germany's debt ratio will exceed 400 percent of G.D.P. by 2030, Italy's will be 700 percent and Canada's will be 250 percent. Only Japan, where fully funded private retirement plans predominate, bucks the trend. Surely the trend cannot continue.

The way most countries in the developed world are attacking the debt problem is by proposing a mix of spending limits and income tax increases. But there is little evidence that tax hikes shrink government deficits. In the United States, total Federal tax receipts rose from $39.4 billion in 1950 to $1,257.7 billion in 1994, a 307 percent increase after inflation. But Federal spending over the same period rose still more rapidly, up 338 percent in real dollars.

This disturbing trend--of spending levels rising faster than revenues--holds for any starting date. In particular, tax increases specifically designed to cut the deficit--as in 1982, 1984 and 1990--often have had the opposite effect. That happens because actual revenues typically fall short of estimates made at the time taxes are increased, while spending has been ratcheted up in the false expectation that extra money will appear.

Canada's recent experience echoes that of the United States. In 1991, Ottawa attempted to close the national deficit with a stiff 7 percent general sales tax. In spite of this tax, the deficit rose, along with interest rates on Canadian Government bonds. In April 1995, Moody's Investors Service downgraded Canada's credit rating.

There are many other examples of higher taxes failing to decrease government deficits. A study of 19 developed countries from 1972 to 1990, by the O.E.C.D., showed no relation between changes in government revenues and changes in government deficits. Those countries that raised taxes most were no less likely to have large deficits than countries with much smaller changes in tax revenue. As a result, experience shows that the only way a government's claim on savings can be halted is to cut its expenditures.

Making such cuts will not be easy, of course. It never is. But if interest rates rise and capital becomes scarce, the culprit is far more likely to be found at home, in the developed world's governing councils, than in the developing world overseas.

What Is the True Cost of Capital?

The price of capital--as measured in real interest rates--is notoriously difficult to estimate.

Generally, what matters to investors is the nominal rate of interest less the expected rate of inflation. But those expectations differ from investor to investor. For foreign investors, exchange rate expectations are yet another factor impinging on the real rate of interest. Even if there were a capital abundance, a volatile or falling dollar would put upward pressure on interest rates since foreign investors would need higher rates to compensate for the dollar's uncertain yield. In a world where capital moves globally, fluctuating exchange rates are a powerful but often overlooked contributor to higher interest rates.

Even so, in historical terms, today's real interest rates are not so very high. In the 1980's--the last time the international economy grew in sync--real rates on 30-year American Treasury bonds averaged about 5 percent, using the Consumer Price Index as the baseline measure of inflation. Today, the real rate is about 4.5 percent, using the same index. Real rates averaged the same 4.5 percent in the period between 1870 and 1975, according to a study by Milton Friedman, the Nobel Prize-winning economist, and Anna Schwartz.

If real interest rates are an indicator of capital scarcities, they have yet to sound an alarm.

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